This article has been written by Saachi Agarwal pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho and edited by Shashawt Kaushik.

This article has been published by Shashwat Kaushik.

Introduction

In our modern world, contracts have become an integral part of our lives. It helps to provide a formal way of communication while protecting our rights. The legislature, as well as the judiciary, has provided several safeguards to protect these rights. Collateral agreements aim to achieve the same and help provide an additional level of security. Although the formal term of collateral agreements as a separate kind might not be known to many, we all, in some way or another, have come across and even dealt with the same in our day-to-day lives. Be it a buyer of goods, an employee, a borrower, a tenant or a policyholder, we all have become recipients of the same and, as such, are subjected to certain rights and liabilities. Thus, it becomes very important for us as individuals to gain an understanding of such contracts so as to equip us to deal with them.

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Understanding collateral agreements

The word collateral is derived from the Latin word ‘collateralis’, where ‘col-‘ means ‘together ‘ and ‘latus’ means ‘side.’ The word ‘collateral’ thus means ‘parallel’ or ‘alongside,’ emphasising the idea of something running alongside or in conjunction with something else. Collateral agreements, in the realm of contracts, refer to supplementary agreements made alongside the main contract, serving as a guarantee or assurance for the fulfilment of obligations and are meant to ensure that the pre-contract promises are met. It is generally formed when one party makes a promise to the other party to induce them to enter into the main contract. Collateral agreements may either be oral or written and are usually made before or simultaneously with the original contract. Collateral contracts are often used in business transactions to ensure that all parties involved are committed to the agreement.

For example, a real estate developer may enter into a collateral contract with a construction company to build a new apartment building. The developer would promise to pay the construction company a certain amount of money in exchange for the company’s promise to build the building according to the developer’s specifications. The collateral contract would serve as a guarantee that the construction company would complete the project, even if the developer were to default on its payments.

Collateral contracts can also be used to protect third parties. For example, a lender may require a borrower to sign a collateral contract with a guarantor. The guarantor would promise to repay the loan if the borrower defaulted. This would protect the lender in case the borrower were unable to repay the loan.

Collateral contracts are a valuable tool for businesses and individuals to protect their interests in business transactions. They can provide a guarantee that all parties involved will uphold their end of the bargain.

Nature of collateral agreements

A collateral contract is independent and separate and exists besides the main contract but is related to and dependent upon it. Thus, if the main contract is deemed illegal, the collateral contract may still be ruled valid and enforceable. The main and collateral contracts are active at the same time, and in some cases, the provisions of the latter may override those of the former. For example, if X (the landlord) agrees to rent an apartment to Y (the tenant), the lease agreement signed by Y with X becomes the main contract. However, if X (the landlord) promises to fix the toilet drainage at the time of letting out the property and fails to do so within the stipulated time period, the main contract may become voidable at the option of the parties.

A person’s promise or representation might not form a term of a main contract, but the courts can still treat it as a binding collateral contract where:

  1. The person making the promise or representation intended it to be legally binding.
  2. The person to whom the promise or representation was made entered into the main contract in reliance on the statement.

Essential elements of collateral agreements

There are seven essential elements necessary to establish collateral contracts.

  • There must be a main contract between the parties.
  • It must be supported by consideration,
  • It must be promissory in nature and such promise must be intended to be legally binding.
  • The promise in the collateral contract must be made to induce the other party to enter into the main contract.
  • The promise must be followed by a statement.
  • It must be consistent with the main contract.
  • It must contain all elements of a contract.

Collateral agreement with a third person

A contract between two persons may be accompanied by a collateral contract between the same parties or between any one of them and a third person relating to the same subject matter. When a person buys goods from a dealer, he is given a “guarantee” in the name of the manufacturer. Here, the main contract of sale is between the customer and the dealer, but the “guarantee” could also be regarded as a collateral contract between the manufacturer and the customer. For instance, when a customer purchases goods from the dealer for consideration, the guarantee from the manufacturer is a collateral contract between the manufacturer and the customer. Again, if payment of such consideration is made via cheque or any credit or other card issued by the bank, the main contract might be between the customer and the shopkeeper, but there is also a contract between the shopkeeper and the issuer of the credit card, by which the latter undertakes that the shopkeeper will be paid.

Again, an arbitration agreement or even an arbitration clause contained in a contract is often referred to as a collateral or ancillary contract in relation to the main contract of which it forms a part. The repudiation or breach of the main contract may not put an end to the arbitration clause, which might still survive for measuring the claims arising out of the breach and for determining the mode of their settlement. However, in the interesting case of National Thermal Power Corporation vs. Singer Company & Ors. (1993), the Apex Court of India held that even though an arbitration agreement can be called a collateral contract, when an arbitration clause is contained in a main contract, it cannot be termed independent since the latter is only a procedural machinery that is activated when disputes arise between parties and has  no meaningful existence except in relation to the rights and liabilities of the parties under the main contract. The law governing such rights and liabilities is the proper law of the contract, and unless otherwise provided, such law governs the whole contract, including the arbitration agreement.

Legal framework

The Indian Contract Act, 1872, is the legislation governing the formation and enforcement of contracts in India. The Act defines a contract as “an agreement enforceable by law.” A collateral contract is a contract that is subordinate to or supportive of a main contract and is dependent on the main contract for its existence. For example, a contract to provide security for a loan is a collateral contract to the loan agreement.

Collateral contracts are governed by the same principles as other contracts, but there are some specific rules that apply to collateral contracts. For example, a collateral contract must be in writing if it is for a sum of money exceeding 100 rupees. Also, a collateral contract cannot be enforced if the main contract is unenforceable.

Collateral contracts can be used to achieve a variety of purposes. For example, a collateral contract can be used to:

  • Provide security for a loan.
  • Assign rights under a contract.
  • Create a guarantee of performance.
  • Distribute the risk of loss in a contract.

Collateral contracts can be a useful tool for businesses and individuals to achieve their contractual goals. However, it is important to understand the legal requirements for collateral contracts in order to avoid any potential problems. While the Act does not explicitly use the term “collateral contract,” it contains provisions that are relevant to the concept. Section 10 of the Act specifies that all agreements are contracts if they are made with the free consent of the parties, for a lawful consideration, and with a lawful object. Collateral contracts must meet these criteria to be valid and enforceable. Consent is said to be free if it is not caused by coercion, undue influence, fraud, misrepresentation, or mistake.

Common examples of collateral contracts

  • Guarantees and surety agreements: When an individual or a business applies for a loan, the bank may require a collateral contract in the form of a guarantee from a third party.
  • Lease agreements: In many cases, a landlord may require a third party to act as a guarantor for the tenant’s lease. The guarantor agrees to be responsible for rent payments and other obligations if the tenant fails to fulfil them.
  • Employment contracts: In employment contracts, there may be collateral agreements related to confidentiality clauses, non-compete clauses, or other post-employment obligations.
  • Construction contracts: In construction projects, contractors may enter into collateral contracts with subcontractors or suppliers for delivery of materials on time, etc.
  • Sale of goods with warranty: When purchasing electronic devices or appliances, manufacturers often provide warranties. Here, the manufacturer promises to repair or replace the product in the event of defects.
  • Insurance policies: Insurance contracts often involve collateral agreements. For instance, in life insurance, a policyholder might have to make a disclosure of health conditions to induce the insurance company to enter into the main insurance contract.
  • Franchise agreements: In franchise relationships, there may be collateral contracts related to the use of trademarks, trade secrets, or other intellectual property.

Cases and precedents

Courts in India have recognised the existence and enforceability of collateral contracts in various cases. Precedents set by the judiciary contribute to the understanding and application of collateral contracts in Indian contract law.

It was held in Shanklin Pier Ltd. vs. Detel Products Ltd. (1951) that where a necessary contractual intention is present, the Courts would treat or would construe an assurance as a collateral contract or warranty conferring a right to damages.

In Firm of Pratapchand Nopaji vs. Firm of Kotrike Venkatta Setty & Sons, etc. (1975), the Apex Court of India held that agreements collateral to prohibited contracts are also unenforceable because a taint attaches to them, which makes them also contrary to public policy.

Remedies for breach

If a party breaches a collateral contract, the innocent party may seek remedies similar to those available for breach of the main contract. Remedies may include:

  • Damages, i.e., monetary compensation;
  • Specific performance requiring the party in breach to fulfil its obligations;
  • Injunction;
  • Rescission or termination of contract;
  • The remedies specified in the collateral agreement itself  in the event of a breach.

Conclusion

Among the various kinds of contracts, collateral contracts play a significant role. These contracts have contributed greatly to the overall stability of financial dealings. However, the law regarding the same is not exhaustive and further growth is required to facilitate smooth dealings in collateral contracts. A clear and precise definition of collateral contracts in legislation, recognition of collateral contracts, especially guarantee agreements, as distinct and enforceable legal agreements, including standardised terms and disclosures for addressing unfair practices, and the incorporation of rules relating to their breach can provide clarity and help avoid confusion.

References

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